“In engineering, people have a big margin of safety. But in the financial world, people don’t give a damn about safety. They let it balloon and balloon and balloon. It’s aided by false accounting.” — Charlie Munger
I love multifamily deals!
Unfortunately. We’ve been seeing some distress in the market.
But don’t worry!
There’s one thing you can do as an investor to protect yourself from a lot of pain.
One of the best things you can do is get into value-add deals.
Today we’re jumping into why I focus on value-add deals.
We’ll also define a value-add deal and why it may provide some safety for your investments.
Warren Buffett’s famous advice really is something to live by in this scenario:
“Rule number one is don’t lose money. Rule number two is don’t forget about rule number one.”
Let’s get into it!
1. Value-Add Deals
What is a value-add deal?
I’m gonna give you an example.
We have properties in Jacksonville, Florida.
The rents there start out around $1,000.
After renovation, they can go up to $1,500.
That’s a pretty nice upside!
But be aware: a lot of deals may look like a value-add but when you look closer, you could start to see things not add up.
Rents may not be solid or there may be hidden costs and fees.
However, if the numbers do check out and the projections are good, that’s awesome!
You’re able to see the upside in rents you want to see.
Warren Buffett says the three most important words in investing are: margin of safety.
Having a margin of safety means you are prepared to weather situations where things don’t go well.
A lot of times I look at projections that only show best-case scenarios.
Recently in Houston, Texas, a $200 million portfolio went bust.
How did that happen?
One reason is that they were not conservative on their projections.
I was recently sent an investment opportunity for apartments in Houston.
The flier said the opportunity was closing soon and the average annual returns are 22% to 30%.
Those are very high returns!
When sophisticated investors see something like this, they’ll back away.
They’ll say it seems like a best-case scenario instead of a realistic scenario.
You want operators who are very conservative.
You need to ask questions like:
Where’s the buffer?
Where’s the margin of safety?
This is the reason why we don’t do Class-A deals.
2. I Don’t Do Class-A Deals
A Class-A deal is a deal that involves a brand-new building built within the last 10 years.
There’s no value to add.
Adding any new additions will not increase rents very much.
Instead, we typically buy properties that are 30 to 40 years old.
We make the properties nicer by renovating.
We’re buying in growing markets.
This is why I’ve felt that Class-A deals, especially those in syndication, are higher-risk deals.
In my opinion, the areas that are the bread and butter of investments are Class B and Class C deals.
They are working class apartments in working class neighborhoods where you can add value.
In Class-A deals, you are often dealing with REITs, which are real estate investment trusts.
These are publicly-traded companies that own a bunch of brand-new real estate and work with a different investment model.
They may put 50% down, but they can go raise more money from the public market syndication.
It’s much tougher for smaller syndicators to do that and raise funds like them.
Everything has to go smoothly and the real estate market as a whole needs to keep rising for these deals to work.
This is why if you’re in a Class-A Multifamily syndication, there may be reason to be a little concerned.
3. Build More Margin in Your Deals
How do we build more margin in our deals?
How do you even find deals that have a margin of safety?
It comes down to conservative underwriting.
Instead of having an 18% or higher projected average on a return, what if it’s 14%?
But on top of that, here are all of these additional upsides if the operator has been conservative.
That sounds pretty good to a concerned investor!
If you want to look for that, ask yourself:
What is the conservative upside?
Don’t think of it as being super conservative.
I’ve seen people before who don’t want in on a deal unless it’s the perfect deal.
If you think that way, you’ll never find a deal to meet those expectations.
I think there’s a happy medium between best case scenario and uber conservative.
It could be thought of as a real-world deal.
Some things will go wrong and some things will go right.
We can meet in the middle.
What does it look like to have a conservative deal today?
Before, I mentioned the example of rents going from $1,000 to $1,500.
That’s called forced appreciation.
You have market appreciation, but you can’t control what that will do. You don’t know if the market will appreciate or fall over the next couple years.
With forced appreciation, we can put $6,000 into a unit and control the upside ourselves.
It’s much safer!
Make sure you’re looking at real world scenarios, ones that are not uber conservative or overly aggressive.
Look at something that’s stress tested and ask questions such as:
What happens if the deal doesn’t perform well or there are delays?
What if interest rates are higher?
What if valuations are lower?
These are all things that go into a conservative deal.
Being conservative really does give you more margin of safety.
When you look at experienced operators, they’ll try to build a lot of margin into deals so they can make sure the deal will perform well.
That’s something we try to do, especially with our partners.
In conclusion: Be conservative in your investments.
Make a plan.
Find a deal that works for you and has a margin of safety.
When you’re talking about not losing money and buying real assets, make sure you’re being consistent and not shooting for the moon.
Now I want to hear from you!
How are you being conservative in your investments?
What margins of safety do you look for?
Let us know in the comments.
Before you leave, make sure to check out our special report about inflation investing. It shares the best choices to invest during an inflationary environment.
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Disclaimer: I am not your investment advisor. This is for educational purposes only. I am not giving specific advice on what you can do. I am simply giving my opinions.